Sunday, December 2, 2007

Prediction Markets are NOT Efficient

how long does it take for a prediction market to incorporate all the available information about an event? Liquidity seems to be an issue for the existing prediction markets, preventing them from reaching equilibrium quickly.

In fact, today's prediction markets are far from being efficient. Ari Gilder and Kevin Lerman, as part of an undegraduate project at University of Pennsylvania supervised by Fernando Pereira, have shown that by using linguistic analysis of news articles it is possible to predict the future price movements of the Iowa Electronic Markets. Therefore, the Iowa markets did not incorporate all the available information. Furthermore, the results indicated that it is possible to predict the price movement by simply using past pricing data. Therefore, the markets were not even weakly efficient. (Kevin is now a first year PhD student at Columbia University.)

One question was whether liquidity played a role in that result. The Iowa markets are thinly traded with upper limit on how much someone can bet. This imposes some artificial constraints making it difficult for information to flow freely into the market. Therefore, it is important to examine other markets with higher liquidity.

Over the last months we have been discussing this issue with George Tziralis, trying to examine how to evaluate the "Efficient Prediction Market" hypothesis. After long discussions, we came up with some techniques for extracting signals from the news about the prediction markets and see whether we can use these signals for predicting the future performance of markets in InTrade. Our sentiment indicator seems to work pretty well, even in liquid markets. Here is a preliminary result for the market on whether Hillary Clinton will be the Democratic Presidential Nominee in 2008:

Our sentiment index (in maroon) is close to 1 when we predict that the market will move higher, and it is close to 0 when we predict that the market will move down. Typically, it works pretty well for predicting long periods of price increases and declines. To put our money where our mouth is, the signal from the last few days shows that Hillary's market price will edge lower in the next few days/weeks.